Bonds are among the most important and widely traded of all securities. Investors value bonds and bond funds for their income and low risk which can balance potentially higher return but riskier stock purchases. If you are a beginning investor you should learn the characteristics of bonds and how this investment tool can diversify and strengthen your portfolio.
A bond is a debt instrument issued by a corporation or government to borrow money. Corporations issue bonds as an alternative to selling equity (stock) to raise capital. Governments use bonds to finance capital expenses such as schools or water and sewer systems, or to finance general expenditures. Bonds have a maturity date that can be anything up to 30 years (and occasionally even longer). When the bond matures, the issuer redeems the bond at its par (face) value.
Corporate and municipal bonds *those issued by states or local governments) typically have par values of $1000 or $5000. US Treasury bonds can have par values of $10,000 or more. Two other types of bonds deserve mention. One is the “zero-coupon” bond. A zero-coupon bond is sold at a large discount off the face value and does not pay interest. Instead, when the bond matures, the investor receives the full face value of the bond. The other is the well-known US savings bond. Like zero-coupon bonds they are sold at a discount. Interest accrues until the bond reaches its full face value at maturity. Savings bonds are non-negotiable (they cannot be bought and sold like other types of bonds).
Regular bonds pay a fixed yearly sum (usually semiannually) called the coupon rate. Bonds are traded much as stocks are, and therefore the price varies. The most important influence on a bond’s price is the prevailing interest rate. If interest rates fall, the bond’s fixed coupon rate becomes more attractive to investors and the bond price may rise above the par value (this is called selling at a premium). If interest rates rise, the opposite is likely true. The coupon rate is less desirable and the bond price tends to fall (if the price drops below the par value, it’s selling at a discount).
Investors speak of the yield of a bond, rather than an interest rate. The yield is the effective interest rate, and is calculated by dividing the coupon rate by the price actually paid for the bond, not the par value. The lower the price, the higher the yield will be. You can use bond yield calculating software online at financial websites like Morningstar.com. Generally, the yield on municipal bonds is lower because the coupon rate paid is normally tax-exempt. This offsets the lower yield, especially if you are in a high tax bracket.
Although short and long term bonds share the same basic structure (with the exception of zero-coupon bonds) short-term bonds (with maturities of less than a year and often less than 90 days) behave a little differently. Due to their short duration, they rarely change much in price, and are redeemed at maturity for the full par value in any case. These are the type of bonds bought and sold by money market funds and are used by corporations and governments to raise cash for immediate needs.
Because bonds must be paid off at face value at maturity, they normally carry far less risk than stocks, but also do not offer the opportunity for equity growth. Bonds are the investment of choice for persons seeking safety and income over equity growth (as a major part of a portfolio after retirement, for example). However, bonds are not entirely without risk. The best bonds are those with top ratings from bond ratings services like Moody’s (moodys.com). If a bond has a low rating or has its rating lowered, it means that the possibility that the issuer may not be able to pay off the bond is higher. Two other factors should be kept in mind. One is that if you buy a bond at a premium and hold it to maturity; you will receive only the par value of the bond, resulting in an equity loss. The other is that some bonds have provisions that allow the issuer to redeem the bond early, which may work to your disadvantage if you bought it at a premium.